Scott et al (eds ) ending government bailouts as we know them (2010)

Ending Government Bailouts As We Know Them Copyright © 2010 by the Board of Trustees of the Leland Stanford Junior University All rights reserved Copyright © 2010 by the Board of Trustees of the Leland Stanford Junior University All rights reserved Ending Government Bailouts As We Know Them edited by Kenneth E Scott George P Shultz John B Taylor authors Nicholas F Brady Darrell Duffie  Joseph Grundfest Richard Herring Thomas M Hoenig Thomas Jackson William F. Kroener III Charles S Morris Kenneth E Scott George P Shultz Kenneth Spong Johannes Stroebel Kimberly Anne Summe John B Taylor Paul Volcker Hoover Institution Press Stanford University Stanford, California Copyright © 2010 by the Board of Trustees of the Leland Stanford Junior University All rights reserved The Hoover Institution on War, Revolution and Peace, founded at Stanford University in 1919 by Herbert Hoover, who went on to become the thirty-first president of the United States, is an interdisciplinary research center for advanced study on domestic and international affairs The views expressed in its publications are entirely those of the authors and not necessarily reflect the views of the staff, officers, or Board of Overseers of the Hoover Institution www.hoover.org Hoover Institution Press Publication No 588 Copyright © 2009 by the Board of Trustees of the Leland Stanford Junior University All rights reserved No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise, without written permission of the publisher Chapter 10, “The Kansas City Plan,” by Thomas M Hoenig, Charles S Morris, and Kenneth Spong, appears in this publication with the permission of the Federal Reserve Bank of Kansas City Copyright © 2009 by the Federal Reserve Bank of Kansas City First printing, 2010 16 15 14 13 12 11 10 Manufactured in the United States of America The paper used in this publication meets the minimum requirements of the American National Standard for Information Sciences— Permanence of Paper for Printed Library Materials, ANSI Z39.48–1992 oo Cataloging-in-Publication Data is available from Library of Congress ISBN 978-0-8179-1124-9 (cloth: alk paper) ISBN 978-0-8179-1123-2 (e-book versions) Copyright © 2010 by the Board of Trustees of the Leland Stanford Junior University All rights reserved Contents ix Preface Kenneth E Scott, George P Shultz, and John B Taylor Acknowledgments xiii Part I The Danger of Bailouts and Key Principles of Reform       Make Failure Tolerable George P. Shultz  Financial Reforms to End Government Bailouts as We Know Them Paul Volcker 11 Fifty Years in the Business: From Wall Street to the Treasury and Beyond Nicholas F Brady 21 Part II Systemic Risk in Theory and in Practice   Defining Systemic Risk Operationally John B Taylor 33   5 Lessons Learned from the Lehman Bankruptcy 59 Kimberly Anne Summe    v Copyright © 2010 by the Board of Trustees of the Leland Stanford Junior University All rights reserved vi   Contents Part III What Financial Firms Can Do       A Contractual Approach to Restructuring  Financial Institutions Darrell Duffie 109 Wind-down Plans as an Alternative to Bailouts: The Cross-Border Challenges Richard J Herring 125 Wind-down Plans, Incomplete Contracting, and Renegotiation Risk: Lessons From Tiger Woods Joseph A Grundfest 163 Part IV Bankruptcy versus Resolution Authority   10 11 12 Expanding FDIC-Style Resolution Authority 179 William F. Kroener III The Kansas City Plan Thomas M Hoenig, Charles S Morris, and Kenneth Spong 189 Chapter 11F: A Proposal for the Use of Bankruptcy to Resolve Financial Institutions Thomas H Jackson 217 Evaluating Failure Resolution Plans  Kenneth E Scott 253 Copyright © 2010 by the Board of Trustees of the Leland Stanford Junior University All rights reserved Contents vii A Summary of the Commentary Johannes Stroebel 263 A Conversation about Key Conclusions George P Shultz and John B Taylor 285 291 Appendix: The Financial Crisis: Causes and Lessons Kenneth E Scott About the Authors Index 313 323 Copyright © 2010 by the Board of Trustees of the Leland Stanford Junior University All rights reserved Copyright © 2010 by the Board of Trustees of the Leland Stanford Junior University All rights reserved Preface Last spring, around the time Congress began considering and modifying the financial reforms proposed by the U.S Treasury, our Working Group on Economic Policy at the Hoover Institution decided to establish a “Resolution Project” to focus on alternative ways to deal with failing financial institutions We were motivated by the growing backlash around the country about the bailouts and our own concerns that the bailout mentality was a grave danger to the country The Resolution Project included Andrew Crockett, Darrell Duffie, Richard Herring, Thomas Jackson, William Kroener, Kenneth Scott, George Shultz, Kimberly Summe, and John Taylor Ken Scott became the chairman of the Project and recruited the participants, organized the meetings, and provided overall leadership The first meeting of the Resolution Project was held in August, and soon we found ourselves diving into the weeds of qualified financial contracts, convertible contingent debt, the third party repo market, and the U.S Bankruptcy Code We had no choice other than to get into these details if we were going to understand, let alone solve, the bailout problem But we also had to be able to pull back from the weeds, and so George Shultz wrote down some broad ideas organized around the theme “Make Failure Tolerable.” From this theme we then decided to broaden our scope and aim the ix Copyright © 2010 by the Board of Trustees of the Leland Stanford Junior University All rights reserved x   Preface work of the Resolution Project toward a conference where we would invite others to speak on related topics or to comment and critique The conference was held in December 2009, and the papers presented there became the chapters in this volume We were delighted that experienced senior policy makers such as Nick Brady, Paul Volcker, Tom Hoenig, and Gary Stern agreed to contribute and that many distinguished attorneys and economists were able to participate and add to the commentary The chapters are organized into four parts Part I starts with George Shultz presenting the ideas and questions that underlie the theme of the book It then moves on to remarks by former Federal Reserve chairman Paul Volcker and former secretary of the Treasury Nicholas Brady All three express their concerns about the dangers of bailouts and call for, among other reforms, tightening the limits on the activities of banks with access to the Fed’s discount window as a way to reduce the likelihood of bailouts Part II then examines the nature of systemic risk, starting with a review by John Taylor of the academic and policy literature and then delving into the experience with the Lehman Brothers bankruptcy by Kimberly Summe A common theme of both the literature review and the practical experience with Lehman is that the direct connection between financial firms appears to be a smaller problem than commonly believed The evidence shows that direct connections between banks in the interbank loan market would not lead to significant cascading and that none of the derivative counterparties to Lehman filed bankruptcy Part III considers reforms that financial firms can implement, whether or not induced or required by government Copyright © 2010 by the Board of Trustees of the Leland Stanford Junior University All rights reserved ... Leland Stanford Junior University All rights reserved Ending Government Bailouts As We Know Them edited by Kenneth E Scott George P Shultz John B Taylor authors Nicholas F Brady Darrell Duffie  Joseph... party repo market, and the U.S Bankruptcy Code We had no choice other than to get into these details if we were going to understand, let alone solve, the bailout problem But we also had to be... alternative ways to deal with failing financial institutions We were motivated by the growing backlash around the country about the bailouts and our own concerns that the bailout mentality was